Return on Your Research Investments

Research by Mary Margaret Myers

The Securities and Exchange Commission (SEC) requires
mutual fund managers to report the asset holdings in their funds on
at least a semiannual basis. These disclosures give competitors and
investors access to otherwise proprietary information. Others can learn
which assets the funds consider attractive and purchase those assets
themselves. Such mandatory reporting limits the amount fund managers
can reap from their research investments.

Several years ago, Vanguard Group stopped the practice of reporting
on cash flowing into and out of each of its funds, because third parties
were using the information in an attempt to "front run" Vanguard
funds. Knowing the largest holdings of a given Vanguard fund and that
the fund had experienced an infusion of cash, the investor might be
able to identify securities in demand in the near future. Fidelity Investments
subsequently took similar action.

Just how much competitive advantage do actively managed mutual funds
potentially sacrifice in these disclosures? In recent research, Mary
Margaret Myers, an assistant professor of accounting at the University
of Chicago Graduate School of Business, along with co-authors James
Poterba from MIT, Douglas Shackelford from the University of North Carolina,
and John Shoven from Stanford University, tackled that question.

In her research paper, "Copycat Funds: Information Disclosure
Regulation and the Returns to Active Management in the Mutual Fund Industry,"
Myers demonstrates that hypothetical copycat mutual funds - funds that
buy the same assets as actively managed funds - earn returns statistically
equivalent to or higher than the funds they mimic, when those returns
are adjusted for expenses.

Copycat funds are at a disadvantage vis-à-vis actively managed
funds, because copycat fund managers can trade on new information only
as often as it's disclosed - as infrequently as twice yearly in the
case of some actively managed funds. In other words, they miss the opportunity
to invest in assets that managers favor between disclosure dates. By
contrast, actively managed fund managers can act immediately on the
results of their research.

But actively managed funds incur research expenses in generating that
information, while copycats have virtually no research expenses.

However, the crucial question is how net-of-expenses returns on actively
managed funds compare with those of copycat funds. Myers investigated
this question by creating hypothetical copycat funds and tracking their
returns vis-à-vis the actively managed funds she mimicked from
1992 to 1999.

Getting on Track

Myers's investigation began with the assumption that the hypothetical
copycat funds could track only the asset selections of the comparable
actively managed, or "primitive" funds, twice yearly, at the
SEC-mandated disclosure dates of 60 days following the end of the fund's
fiscal year, and 60 days after the end of its fiscal second quarter.
That assumption is considered conservative. More frequent voluntary
disclosure would result in even closer tracking of funds.

To provide an example of this conservative assumption, a fund with
a calendar-year end would have to report at the end of February and
again at the end of August. The copycat fund's assets would be purchased
at those disclosure dates, and the copycat's performance would be compared
over the next six months against the underlying primitive fund.

Assuming the potential net return advantage of copycat funds would
be greatest versus primitive funds with high expense ratios, Myers examined
a sample of large equity funds with high expenses, but repeated the
analysis on a broader sample of funds.

The first, high-expense fund sample was made up of 20 equity funds
whose large size and investor fees made them most susceptible to copycats.
The second sample was comprised of the 100 largest funds (by net asset
value) from a broader range of equity funds.

Taking a Closer Look

Myers examined the first sample and their hypothetical copycats, finding
the mean return on the high-expense ratio primitive funds greater than
the mean return on the copycat funds. But only in the sixth month was
the differential significant. Not surprisingly, the gap in returns between
primitive and the hypothetical copycat funds widened with the passing
months, reflecting the copycats' declining ability to track their counterparts.

However, when the fund returns were adjusted for estimated monthly
expenses, the copycat funds outperformed the primitive funds she mimicked
in four of the six months, with the spread remaining insignificantly
different from zero except in the fourth month. The basic finding: Copycat
returns and primitive fund returns are not statistically different.

In addition to monthly returns, buy-and-hold returns were examined,
finding much the same thing: The difference between primitive fund returns
and copycat fund returns at the end of the six-month holding period
was not significantly different.

The suggestion from the high-expense ratio sample is that the hypo-thetical
copycat funds can track actively managed funds for up to six months
after portfolio disclosures. What's more, the differences in returns
are statistically insignificant whether or not the actively managed
funds' expenses are deducted. That would also suggest that copycats
should enjoy substantially higher returns once the additional costs
of active management are factored in. Those costs, such as taxes and
brokerage fees, were not considered in Myers's analysis.

Analyzing the second, broader sample, Myers found that relaxing the
restrictions did little to change the findings. Looking at monthly returns,
the primitive funds out-returned their corresponding copycat funds in
four of six months, but not by significant margins.

However, when annual expenses were deducted from the returns or when
the sample was restricted to the observations for which asset allocation
is measured most precisely, the hypothetical copycats outperformed the
primitive funds in five of the six months, but the difference was statistically
significant only in one of the six months.

The buy-and-hold results produced much the same findings. Myers found
that the difference between the primitive funds' buy-and-hold returns
before expenses and the copycat funds' buy-and-hold returns before expenses
at the conclusion of the six-month holding period was not significant.
However, the net-of-expense, buy-and-hold returns for the copycat funds
was significantly higher than the primitive funds over a six-month period.

In both samples, differences in pre-expense returns between copycats
and actively managed funds declined with the percentage of fund assets
that could be identified by the University of Chicago's Center for Research
in Security Prices (CRSP). In short, the more assets that are known,
the less able a fund manager is to earn superior results.

The End Game

Using a model designed to assess the factors determining the hypothetical
copycat fund's precision in tracking the primitive fund, Myers found
as expected that the absolute difference in returns decreased with the
percentage of known holdings, and increased with the amount of turnover
in both samples.

Her findings support the idea that funds with more assets invested
in identifiable securities are easier to track, and funds that turn
over their portfolios are harder to track.

"It makes sense that copycats are better able to mimic the performance
of funds that trade infrequently, because a copycat would exactly match
the performance of a fund that never traded," says Myers.

The broader sample findings also indicated that higher expenses and
longer management tenure make mutual funds harder to track, while market
capitalization of the funds' holdings make them easier to track.

Myers concludes that actively managed funds outperform copycat funds
when returns before expenses are examined. But the returns net of expenses
- the returns available to mutual fund investors - favor the hypothetical
copycat funds. The return differential favors the copycat funds more
in a broader sample than it does in a high-expense ratio sample.

Myers suggested subsequent research might examine the extent to which
actively managed fund managers can stymie copycat funds through the
use of "window dressing."

Window dressing is a strategy in which managers sell particularly attractive
issues just before disclosure, only to purchase them again immediately
following disclosure. Myers notes that window dressing would make the
most sense if the securities in question are those of large companies
whose shares trade actively in liquid markets, and less sense in the
case of smaller and less liquid securities, whose transaction costs
would outweigh the benefits of window dressing.

Myers's findings also raise several questions about regulatory policy
design. Among them is the question of whether mandatory disclosure is
appropriate, and if so, how often.

If concerned that a fund manager will invest assets irresponsibly,
investors are likely to demand disclosure. But if they believe that
the
benefits of not disclosing positive return opportunities exceed the
risks of manager malfeasance, they may choose a fund that does not disclose.

Given the potential complexity of information disclosure regulations,
Myers concludes that future regulatory policy decisions should take
into consideration not only the potential gain to investors from disclosures,
but also the potential costs to firms associated with those disclosures.
- J.S.

Mary Margaret Myers is Assistant Professor of Accounting at the University
of Chicago Graduate School of Business.